Sandwiched by powerful forces?

THE consumer staples sector, notably the food and beverage (F&B) sector, draws investor attention for good reason. Everyone needs food. It is an easy sector to understand.

Yet the economic theory is a bit grimmer, as F&B market structure approximates what economists call perfect competition.

In this structure, there are numerous buyers and sellers of identical products. Barriers to entry are non-existent. Firms have tiny market shares and a limited influence on prices. If a chicken rice stall tries to charge 50 cents more for a basic plate, most people will just visit the stall next door. Profit margins are thus thin and constantly under threat.

The real world is imperfect, so economists in the 20th century have coined a confusingly named type of imperfect competition called monopolistic competition.

Here, products are similar but not identical. Firms differentiate themselves through branding or marketing, in order to make short-term profits.

In the long run, goes the theory, these firms can only break even.

While these companies can always make an accounting profit, meaning there might be excess money after operating costs are deducted from revenues, they can't make an economic profit in the long run, a concept which factors in opportunity costs.

If this were true, this means companies operating in monopolistic competition can only recover the opportunity costs of their investors in the long run.

Investors would be better off in oligopolistic markets where there are high barriers to entry, and where incumbents have pricing power.

That is just theory.

In the real world, some F&B brands are able to thrive in monopolistic competition and make enormous pots of money over time. Coca-Cola and McDonald's are two examples.

Today, we discuss some F&B companies operating in South-east Asia. On the surface, they have been reasonably successful despite low barriers to entry in their product of choice: Bread.

Give me a raise

Breadmaking requires an oven, flour, and some yeast. You can make the dough and bake the bread at home, using a machine that costs just a few hundred dollars. Neighbourhood bakeries are a dime a dozen. You don't really hear of bread chain billionaires.

Yet there are a number of well-known giants. Gardenia bread maker QAF is the dominant bread supplier here and in Malaysia. Through the years, it has generated respectable operating margins of around 10 per cent for its bakery operations, sometimes more, while defending its perch at the top. (Attracted by the brand sometime back, I bought a negligible stake to monitor further.)

In Asia, one of the oldest listed bakeries is Japan's Yamazaki Baking Co. The firm itself has been around for almost 70 years. It even opened some Singapore outlets. But operating margins are painfully thin, at 2 to 3 per cent. The firm is also struggling with a shortage of labour.

The fact that bakeries like Yamazaki and QAF have been around for decades says something.

I asked some investors how companies facing near-perfect competition survive. Astral Asset Management's Lee Kian Soon cites three ways: Innovation, economies of scale, and brand loyalty. Skilled management can build on the above three measures to build a small moat around their business, he said.

Brand loyalty is built through ensuring consistency of quality. Innovation can keep the brand in customers' minds, and might even allow a company to refresh a brand with a higher price.

Mr Lee cites McDonald's McSpicy burger. "It used to be a double patty burger. One day, they reduced it to a single patty burger at a slightly reduced price. A few months later, they put back the double patty burger at a much higher price point."

Azure Capital chief executive Terence Wong said a firm facing fierce competition might nevertheless perform after a period of industry consolidation. "The strongest competitor should, after a period of hardship, be able to rise back up," he said.

Observers say that for companies like QAF and Yamazaki, scale matters. Raw materials like flour, sugar and yeast can be procured in bulk at cheaper prices. Perhaps innovation might help. Gardenia and Sunshine have rolled out super-fine or soft grain loaves in Singapore, and higher quality speciality bread alternatives.

Bread pits

However, QAF and Yamazaki haven't done fantastically well for investors in the long run.

Based on Bloomberg data, QAF gave shareholders annual price returns of just 3.2 per cent a year from end-April 1986 until end-July 2017. This is despite a significant rally in recent years.

Yamazaki, which sells biscuits, crackers and prepared rice in addition to various baked goods and bread, is only somewhat better. Price returns were just 4.2 per cent a year from end-September 1974 until end-July 2017, albeit through a severe deflationary period.

What explains their middling performance? Is it the curse of monopolistic competition, or something else?

When examining the history of sliced bread firms in Singapore, it seems that managers got too ambitious and also made sub-optimal investment decisions.

Sunshine Bread maker Auric Pacific made costly acquisitions of Delifrance and Food Junction in 2007-8, which made losses for many years. QAF's purchase of China apple juice firm Shaanxi Hengxing Fruit Juice in 2005 eventually ended in impairments and a sale.

So one thing to watch out for is how shareholder value can be destroyed by managerial mistakes. As veteran fund manager Tan Chong Koay put it, expansions into new markets usually don't work out.

"Of course, you talk to management, but sometimes a company visit doesn't count," he said. "Management is so protective (of their plans), and say, 'we're OK, going into this new field.' Most of the time it's not OK, and it turns out to be disappointing."

Sometimes, what hits a company can also be completely unexpected.

In Indonesia, a company called Nippon Indosari Corpindo sells the popular Sari Roti brand of bread. For many years since its listing in 2010, the company was reporting strong double-digit operating margins and substantial revenue growth. Share prices soared multifold.

Then came end-2016, when religious tensions heated up around the then-incumbent Christian Jakarta governor popularly known as Ahok. At an anti-Ahok rally, Sari Roti hawkers carried signs that the bread was free for Muslims. The company swiftly clarified that it was not involved.

Yet that ironically might have been a public relations mistake. Bread suddenly became political. The firm came under fire for supposed Ahok sympathies. A social media campaign to boycott Sari Roti took hold.

Though the impact of the boycott is expected to pass, it had an impact on sales. Meanwhile, brokers have been cutting their ratings on the counter. They cited competition from QAF's end-2016 entry into Indonesia and higher wheat prices, among other things.

So industry structure is perhaps just one of many factors investors have to consider. Other important factors include price, the competitive and cost environment, and managerial skills.

Ultimately, the above discussion is not just relevant for bread and F&B. Think about the numerous industries that are getting disrupted by the Internet. For them, it's a perfect competition world out there. With the right strategies, perhaps some profits are still possible for the upper crust.